Insights and Opinions

Thursday, January 4, 2007

The Angel Funding Process

Angel funding for growing companies is a mysterious process to most entrepreneurs. Somewhere between hitting up your rich uncle and begging for a loan at the bank, a professional angel group can provide $250,000 to $1.5m in equity funds to accelerate growth and make it attractive to later stage investors.

Realistically, getting a group of angels behind you is a lot like herding cats. Angel groups are voluntary, consensus-driven organizations, and decision-making is not the quickest. Angels invest as individuals, not as a fund (like a VC). On the other hand, you can get some very high-level people excited about your venture, and they will contribute not just cash, but advice, contacts and mentorship. Angels want to be on the entrepreneur’s side.

Our executive team at the Pasadena Angels presented a detailed workshop a few days ago, and I thought I’d offer my explanation of the process. Here’s how to avoid the herding cats scenario:

Steps in Angel Funding:

Origination / Screening

Evaluation / Due Diligence

Risk Assessment / Valuation

Structuring / Negotiation

Documentation / Closing

Representation / Tracking

I’ll deal with each of these briefly below and in later posts.

1. Origination / Screening
All angel groups have a funnel or pipeline of new projects. Pasadena Angels are merit-based, in that all deals properly submitted to the website are considered by at least one Angel. You don’t have to be a friend of an angel, but the more contacts you cultivate, the better. We find deals when attending conferences, networking events and even from ideas germinated by our members.

Once a deal is submitted, it goes through a screening process. An angel reads through the documents, determines if the deal fits within the angels’ “sweet spot”, and typically speaks with or meets the entrepreneur once or twice. If the company is out of the area, or asking for more than $1.5m or thinks they’re already worth more than $5m, then they typically will be dinged right away… Those that get through are asked to present to a larger screening committee.

2. Evaluation / Due Diligence
The few companies which get past the screening process (perhaps 2-3 per month), and which draw the interest of, say, 10 or more Angels, will begin a more formalized evaluation process. This is a phase where prospective investors check out an entrepreneur’s references, verify that the books are in order, validate the product and commercial market, etc. An angel group is typically a forum to learn about new deals and exchange information; the group itself does not invest. So, it is up to each angel to do their individual due diligence to satisfy their personal criteria whether to invest or not. Being in a group makes this process more efficient, both for the investors and the entrepreneur.

3. Risk Assessment / Valuation
Assuming the evaluation goes well, the angels and/or entrepreneur will draft a Term Sheet and determine a “pre-money” valuation of the company. This is the value of the company before an investment is made. Entrepreneurs come up with fancy justifications for why they’re worth $10m to $100m - while looking for a $500k investment. It won’t work. Ultimately, angels make a personal risk assessment of the opportunity and assign a valuation based on that. It’s as much art as science. What’s your company’s pre-money valuation? That’s a book in itself; I’ll clarify later.

4. Structuring / NegotiationA “term sheet” defines the structure of a deal, and this would include, among many other provisions, how much cash is invested, whether that is for preferred stock (equity) or a convertible note (debt), how dividends would accumulate and be paid out, expectations for the entrepreneur and management team, composition of the board of directors, etc. Both investors and the entrepreneur will be represented by lawyers. If you’re an entrepreneur, be sure you have a lawyer skilled and experienced in small-company angel financing, otherwise, they will inadvertently sabotage your deal. An entrepreneur who lets the angels draft the term sheet (but of course negotiates the terms) will definitely get a deal done more quickly. The key is to keep it simple.

5. Documentation / ClosingOnce a term sheet has been agreed by both sides, the complete deal is presented to the whole angel membership. At that point, it’s put up or shut up, and the angels begin writing checks. Even more thorough documents are drafted (basically, advanced legalese of the term sheet). If a minimum amount of funds are raised, then the deal can close. At that moment, the company gets the money. End of story, right?

6. Representation / TrackingThrough the years, angels have been burned by investing their good money in entrepreneurs who then proceeded to do whatever they wanted. Nowadays, with more organized angel groups, angels expect seats on the board of directors (representation), demand to know what’s going on in the company and reserve the right to change course, if the entrepreneur heads in a bad direction. To avoid that unfortunate scenario, angels track their investments and expect the company to provide ongoing reports. This could be a monthly status, quarterly financials, conference call updates, etc. From my own experience, this is a great discipline to have. The more open an entrepreneur is, the greater cooperation they will receive from angels.

Many entrepreneurs hope for “dumb money” angels — someone who throws in their money and otherwise doesn’t bother the entrepreneur. If you can find dumb money, go for it - but it really won’t grow your business. It may even scare off later investors. Angels want to be involved in a positive way. They don’t want to meddle; they’d rather be advisors and mentors.

Having angels in your company is like having the toughest professor at college: the course was a b*tch, but afterwards, you realize you learned more than in any other course. Ultimately, it will lead to higher rewards - both for the entrepreneur and the investors.

Ken Hayes is a member of the Pasadena Angels and entrepreneur and investor in early stage technology companies. His specialty is in finding, screening and mentoring companies as part of the angel investment process. Prior to returning to Los Angeles to work in Internet advertising, Ken founded and built up one of the largest e-learning companies in Scandinavia. Way back in the mid-90's he was
on the European Management Team of Dell Computer Corporation and earned an MBA from INSEAD, France, to go with his BA from Pomona College. See his blog at http://kbhayes.com